2nd June 2010

A look at how post-panic bottoms form

Many traders want to know if the market is undergoing a bottoming process or if it's rather setting up for a fresh decline to lower lows. We’ll attempt to provide an answer to that question in this commentary.

When we're dealing with the stock market we're always dealing with best "guesstimates" which means there can never been absolute certainty regarding the market's intent. Technical analysis allows us to follow the path of least resistance when internal momentum is accelerating and the market is trending higher (or vice versa) and it can often tell us when the market is being set up for a reversal of trend. But what of those periods -- like now -- when the market has undergone a sharp decline, loses internal momentum, yet shows no clear directional bias? In cases like this the internal momentum indicators are of little value. The cycles can be useful but ultimately cannot guarantee the market's next directional move since it requires velocity to get the movement started.

In such cases the most important thing we can look to is stock market psychology. We know that the market's chief goal is to separate investors from their money, which is why the market typically does the opposite of what the majority of investors believe it will do. Investor sentiment following a market panic tells us whether the average market participant is hopeful and optimistic that the market will soon recover after a steep decline (which is bearish from a contrarian standpoint). It can also tell us to expect a recovery after a panic if the public is pessimistic regarding the market's recovery potential. When the public begins to sell short and buy put options according to the various put/call ratios, it tends to built a heavy short interest from which the market can launch a short-covering rally (to the great surprise of the public).

The CBOE put/call ratio tells us the public is still overly bearish following the panic of two weeks ago. There's hardly a bull among the retail investor crowd right now, which supports the stock market's "wall of worry." And even the volatile AAII investor sentiment poll is net neutral with only 36 percent of investors expressing any bullish sentiment against a 36 percent bearish sentiment.

Moreover, the number of stocks making new 52-week lows has been contracting in recent days since the selling panic, indicating a diminution of internal selling pressure. This is important following a huge decline, for if the new lows were to remain stubbornly high for several consecutive days it would mean the market is more than likely setting up for another decline.

The next best thing we can do to tell us what we might expect following a selling panic is to observe the market's action following previous declines when the technical and psychological indications were similar to today. One of the closest parallels I can find is the news-related selling panic of late February 2007. We discussed this in a previous report but I think it's worth a closer look since it's typical of what happens following a panic. The market usually needs at least three weeks of consolidation after a steep decline before it's ready to break out again and confirm a buy signal relative to the 15-day moving average.

Following the late February '07 sell-off, the SPX didn't confirm a buy until three weeks after the panic. If the February '07 panic is any guide (and I think it probably is), we can expect to see the SPX confirming a breakout fairly soon. The important thing to monitor for now is the number of stocks making new 52-week lows and the investor sentiment polls and put/call ratios.

Gold mining stocks

Concerning the mining stock outlook, we previously questioned the negative divergence signal that our old, trusty leading indicator stock Freeport-McMoRan Copper & Gold (FCX) was sending in April and earlier May. While the XAU index continued to trend higher, FCX and other leading indicator stocks were in a steady decline. Ordinarily the lag between the divergences in FCX and the XAU index doesn’t last more than a few days but in this case it lasted nearly six weeks. Alas, FCX and the other leading indicator stocks were telling the truth as it turned out as finally the gold and silver stocks comprising the XAU collapsed along with the broad market two weeks ago.

It stands to reason that as Freeport was among the first of the important leading stocks to go into decline back in April, it should be among the first to bottom out and turn up again ahead of the XAU components. Already we have a preliminary sign beginning on Friday, May 21, that FCX may be on the verge of reversing its immediate-term downtrend. A confirmed breakout above the 15-day moving average (blue line) for FCX would confirm that the downtrend has been broken and would also be a bullish leading signal for the XAU.

--Clif Droke
clif@clifdroke.com

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